1
Chapter 13 Chapter 12
Communication and Governance
Discussion Questions
1. Amazon’s inventory increased from $3.2 billion on December 31, 2010, to $5.0 billion one
year later. In addition, sales for the fourth quarter of those years increased from $12.9 billion
in 2010 to $17.4 billion in 2011. What is the implied annualized inventory turnover for
Amazon for these years? What different interpretations about future performance could a
financial analyst infer from this change? What information could Amazon’s management
provide to investors to clarify the change in inventory turnover? What are the costs and
benefits to Amazon from disclosing this information? What issues does this change raise for
the auditor? What additional tests would you want to conduct as Amazon’s auditor?
Amazon had annualized sales of $51.6 billion and an implied annualized inventory turnover rate of 16.1 at
the end of 2010 and $69.6 billion and 13.9, respectively, at the end of 2011.
To clarify the reasons for changes in inventory turnover, Amazon could provide information about:
• The types of products in inventory. Is the inventory mainly old products that have not sold and
will have to be deeply discounted or written-off or is it new, popular products that have not yet
The costs of providing this type of additional information include:
• Disclosure of proprietary information about the firm. Amazon’s competitors could use this
information to adjust their business plans;
2 Instructor’s Manual
The benefits of providing this type of additional information include:
• Provide analysts and investors with a better understanding of the firm’s plans; and
2. a. What are likely to be the long-term critical success factors for the following types of firms?
• a high-technology company, such as Microsoft
• a large, low-cost retailer such as Wal-Mart
Critical success factors for a high-tech firm, such as Microsoft:
Critical success factors for a large, low-cost retailer, such as Wal-Mart:
2. b. How useful is financial accounting data for evaluating how well these two companies are managing
their critical success factors? What other types of information would be useful in your evaluation? What
are the costs and benefits to these companies from disclosing this type of information to investors?
For a high-tech firm, non-financial accounting types of useful information could include:
Chapter 12 Communication and Governance 3
• Long-term strategy for the firm;
For a large, low-cost retailer, types of useful non-financial accounting information could include:
• Long-term strategy of the firm;
• Sales and profitability per store, per existing store, per new store, and by region of the country;
In general, both types of firms will benefit from greater disclosure by increasing analysts’ and
investors’ understandings of the firm. They will both bear costs related to the release of proprietary
information to competitors, decreased credibility if subsequent actions and results do not match the
disclosure, and legal liability from dissatisfied investors.
Overall, the benefits and costs of disclosing this type of information are likely to be greater for the
high-technology firm than for the low-cost retailer. Financial statement information will typically
4 Instructor’s Manual
3. Management frequently objects to disclosing additional information on the grounds that it is
proprietary. For instance, when the FASB proposed to expand disclosures on (a) accounting for stock-
based employee compensation (issued in December 2002) and (b) business segment performance (issued
in June 1997), many corporate managers expressed strong opposition to both proposals. What are the
potential proprietary costs from expanded disclosures in each of these areas? If you conclude that
proprietary costs are relatively low for either, what alternative explanations do you have for
management’s opposition?
Expanded disclosure standards require firms to report using the same segments used for internal
reporting and organization. This information potentially provides additional information to a
Management’s opposition to the ongoing debates about whether to record an expense for stock
options can probably be better explained by management’s concerns about providing stockholders
4. In contrast to U.S. GAAP, IFRS permits management to reverse impairment on fixed assets which
have increased in value since the time of their impairment. Revaluations are typically based on estimates
of realizable value made by management or independent valuers. Do you expect that these accounting
standards will make earnings and book values more or less useful to investors? Explain why or why not.
How can management make these types of disclosures more credible?
The usefulness of earnings and book values will depend on any information asymmetry between
management and investors as well as management’s incentives to manage reported performance
Chapter 12 Communication and Governance 5
5. Under a management buyout, the top management of a firm offers to buy the company from its
stockholders, usually at a premium over its current stock price. The management team puts up its own
capital to finance the acquisition, with additional financing typically coming from a private buyout firm
and private debt. If management is interested in making such an offer for its firm in the near future, what
are its financial reporting incentives? How do these differ from the incentives of management that are not
interested in a buyout? How would you respond to a proposed management buyout if you were the firm’s
auditor? What about if you were a member of the audit committee?
If management is interested in making a buyout offer for the firm, its primary concern may be
paying as low a price as possible. This goal may give management an incentive to use accounting
discretion to make the firm appear to be under-performing. This “bad news” might lower the stock
Management incentives for reporting prior to a management buyout should be of interest to the
external auditor and audit committee because they could affect the firm’s reporting. If management
has incentives to understate performance, to be able to acquire the firm at a low price, the auditors
6. You are approached by the management of a small start-up company that is planning to go public. The
founders are unsure about how aggressive they should be in their accounting decisions as they come to
the market. John Smith, the CEO, asserts: “We might as well take full advantage of any discretion offered
by accounting rules, since the market will be expecting us to do so.” What are the pros and cons of this
strategy? As the partner of a major audit firm, what type of analysis would you perform before deciding to
take on a new start-up that is planning to go public?
6 Instructor’s Manual
Pros
Generate better-looking financial statements. More aggressive accounting decisions could make the
firm’s performance appear better than it would otherwise.
Cons
Difficulties with auditors. The firm’s auditors would have to approve the aggressive accounting
decisions by the firm. If the auditors did not sign off on some of the firm’s choices, then the firm
would have to make less aggressive accounting choices or change accounting firms. Either of these
changes could serve as a warning about the firm to potential investors.
7. Two years after a successful public offering, the CEO of a biotechnology company is concerned about
stock market uncertainty surrounding the potential of new drugs in the development pipeline. In his
discussion with you, the CEO notes that even though they have recently made significant progress in their
internal R&D efforts, the stock has performed poorly. What options does he have to help convince
investors of the value of the new products? Which of these options are likely to be feasible?
The CEO could potentially take advantage of the following options to provide information about the
value of the firm’s new projects:
Chapter 12 Communication and Governance 7
• Analysts meetings
• Voluntary disclosure of internal R&D efforts
While each of these options could be used to communicate directly or signal management’s private
Stock repurchases and initiating/increasing the dividend are likely to be infeasible. Both of these
Analysts meetings and increased voluntary disclosure are more likely actions for the firm. These
Sale of a block of stock to a pharmaceutical company or other knowledgeable firm would also be
feasible for the firm to do. It would signal to outsider investors and analysts that a very
8. Why might the CEO of the biotechnology firm discussed in Question 7 be concerned about the firm
being undervalued? Would the CEO be equally concerned if the stock were overvalued? Do you believe
that the CEO would attempt to correct the market’s perception in this overvaluation case? How would you
react to company concern about market under- or overvaluation if you were the firm’s auditor? Or if you
were a member of the audit committee?
The CEO could be concerned about the firm being undervalued for several reasons. First, an
undervalued firm makes a good takeover target. Once another firm discovers that the firm is
8 Instructor’s Manual
The CEO has different incentives to take action if he believes that the firm is overvalued. Equity
capital is less expensive to raise if the firm is overvalued. Academic research suggests that there are
more equity issues during periods when firms are likely to be overvalued. In addition, the CEO’s
bonus may depend on the firm’s value. If the stock price falls as a result of his actions, the CEO
9. When companies decide to shift from private to public financing by making an initial public offering
for their stock, they are likely to face increased costs of investor communications. Given this additional
cost, why would firms opt to go public?
Despite the increased costs of investor communications, firms go public for many reasons,
including:
• Improved access to capital markets. Some quickly growing firms find their growth outstrips the
ability of their private funding sources. Some firms find it easier and less expensive to raise
• A significant portion of employees’ wealth is the firm’s stock. Just like publicly held firms, many
Chapter 12 Communication and Governance 9
• Provide outside value for the firm. It is difficult to value the equity of a privately held firm. A
company will often sell a share of its equity to get better information about the value of the
10. German firms are traditionally financed by banks, which have representatives on the companies’
boards. How would communication challenges differ for these firms relative to U.S. firms, which rely
more on public financing?
German firms face a different set of communications challenges than American firms, due to
variations in the ownership structure. Relative to American firms, German firms tend to have far